MR. REED. Mr. President, I rise today to urge my colleagues to reject the proposal by Senator Shelby and Senator Chambliss. It is well intentioned. It is designed, as other proposals are, to try to provide some appropriate regulation to a very complex and complicated area of financial transactions--derivatives.
Like my colleagues, I have spent some time trying to understand this area. The only major point I can make is that in concept, derivatives are simple. It is a contract that derives its value from reference to another entity such as soybeans or mortgages. That is where the simplicity stops.
These financial instruments are incredibly complicated, and they have been made more so by very sophisticated financial engineers on Wall Street.
What we have recognized in the last several months is we have to take an appropriate step to regulate their sale in the United States and, frankly, influence the worldwide sale and use of derivatives.
The Dodd-Lincoln proposal in this bill is, I think, not only a principled but an effective way to deal with the issue of the sale and use of derivatives. They start off with a premise which is fundamental: We need transparency in the marketplace. There was no transparency in the marketplace when it came to derivatives.
Senator Levin held hearings which brought forth individuals from Wall Street, from Goldman Sachs. Frankly, if you listen to the hearings, even they did not understand the products they were selling--complicated, deduced, created by Ph.Ds in mathematics using supercomputers. We need transparency. People have to know what they are selling. Apparently, some people on Wall Street did not even know what they were selling. But certainly consumers have to know what they are buying. Transparency is the key.
The way you arrive at it, in my view, is the way this underlying legislation Chairman Dodd has sponsored, along with Chairman LINCOLN, does.
First, it establishes the requirement that all derivatives transactions be reported to a repository so that regulators will have a sense of where the market is moving in terms of specific products.
Second, there is a requirement that you clear these products. Clearing is absolutely critical because an over-the-counter transaction is bilateral in nature. It is someone dealing directly with another party. What you have there is the danger of counterparty risk, the fact that one side of the transaction cannot perform. They go bankrupt, they do not have the resources, they miscalculated tremendously as to the nature of this transaction. And their failure affects other financial institutions.
In those bilateral situations, the danger for counterparty risk is significant. To minimize that, you put it on a clearing platform. You put a party between the two parties of the contract who will assess collateral and margin and do it in a systematic way. These transactions on a clearing platform will be more transparent and there will be reduced risk between counterparties. That is, I think, a sensible and, at this point, nondebatable point because the Chambliss proposal also has a clearing platform aspect to it.
But the next step--and I think it is an essential step--is to move to a trading platform because there you further reduce and manage counterparty risk because it is not just an intermediary clearinghouse that is handling the risk, it is participation in a market. It is individuals who broker deals who come in and buy and leave. It is at the heart of price discovery because the key aspect in all of these discussions is what is this instrument worth? Is it worth $100 or $2? If I am betting it is worth $100 and, of course, it is $2, I will lose. If I am betting it is $5 or $6 and it is $100, I lose on the other side.
Part of this is essential price discovery. This is an esoteric point. It goes right to the nature of our markets--price discovery. That is why we all claim markets are the best form of economic transaction because in a market, you know the price, and if you can meet the price, you can make the transaction.
One of the things that is implied in a marketplace, though, in Econ 101, is perfect information. Buyers and sellers each know what it costs. One of the problems with the derivatives markets is information is asymmetric, it is skewed, it is dramatically skewed to the Wall Street insiders who designed these products. That was one of the lessons of the Goldman Sachs hearings: Who knew what these things were? They did not even know, but they knew a lot more than people they were selling them to.
We have to reduce that asymmetric nature of the market, and the best place to do that is not simply clearing a product, having someone say you have to have this much margin if you want to participate, but actually trade in the product. Again, this is not an academic issue.
Let me paraphrase a story from Michael Lewis's book called The Big Short.'' On February 21, 2007, the market began to trade an index of collateralized debt obligations. They called it the TABX--T-A-B-X. For the first time, everyone in the marketplace could actually see on a screen what these CDOs were worth, what someone was going to pay for them. No longer were they waiting on just the dealer, the Wall Street insiders saying: No, no, these are great, buy them; they are terrific, buy them. There was a price. The price confirmed a simple thesis in a way that as Lewis says no amount of conversations with market insiders ever could ever have.
After the first day of trading, those AA-rated tranches closed at 49.25 from a par value of 100. They lost more than half their value in one day of trading. There was now this huge disconnect, and I quote:
With one hand the Wall Street firms were selling low interest rate-bearing double-A rated CDOs at par, or 100; with the other hand they were trading this index composed of those very same bonds for 49 cents on the dollar. In a flurry of e-mails, their sales people at Morgan Stanley and Deutche Bank tried to explain to clients that they should not deduce anything about the value of their bets against subprime CDOs from the prices on these new, publicly traded subprime CDOs. That it was all very complicated.
Trading illustrates the real value of a product. When the Shelby-Chambliss proposal says, We are not going to trade these, what they are saying is business as usual. Let's let those folks on Wall Street tell us what they are worth. Tell it to the banks, the small community banks, tell it to the farmers, tell it to all those business men and women at the National Association of Manufacturers, this is what it is worth. They will not have to explain the fact that a market might rate it half of what they are claiming the value is.
If we really want to reform what is happening on Wall Street, we are not going to abandon the requirement to trade as many products as we can trade.
I will admit some products are so unique that a trading market might not be established. But the presumption by Wall Street--in fact, I think the head of J.P. Morgan said practically 70 percent of the derivatives could be cleared and probably a significant fraction of that could be traded. If you want transparency, if you want price discovery, if you want efficient markets, reject the Chambliss proposal, support the Dodd proposal.
There is another aspect of the bill, and that is section 716, which does not deal with the mechanics of trading derivatives as much as who can do it. Can it be in a bank? Must it be separated? There are discussions about different approaches. Senator Levin and Senator Merkley have an approach that bars proprietary trading, that would leave that out of the bank but still leave traditional hedging within the bank. That is part of the debate. That, I think, is a seriously significant open question. In my mind, there is absolutely no question that to accept the Chambliss-Shelby approach that doesn't require trading is the wrong way to proceed.
There is another issue here, too, and that goes to the nature of these over-the-counter contracts. Some of them could be cleared, but some are so unique they cannot. It goes to the exemption for end-users. In the Dodd bill, they have made a successful attempt to separate those over-the-counter transactions which have an economic rationale--it is an airliner hedging their fuel prices--and they have done it in a way which makes sure that this is not a loophole for the sophisticated financial engineer to exploit but a way in which business can continue to conduct their operations.
The exceptions in the Shelby-Chambliss amendment are much too large. In fact, I think this is a drafting error, but as I read the amendment, it could be read as only requiring clearing of swaps between two counterparties under common ownership within the same company, which essentially means there is no requirement whatsoever. I do not think that is what the sponsors proposed but that is what the language says, at least as I read it.
If you want huge loopholes to begin this process, support this amendment. If you want to maintain well-structured exemptions for the economic use of derivatives, that is incorporated within the underlying Dodd-Lincoln bill, and it makes a great deal of sense to me.
There are issues here we have to be conscious of and we can still debate about the allocation of responsibilities between regulatory authorities with respect to these derivatives. That is an issue that I think is still outstanding. But the underlying architecture of derivative regulation has been accomplished by Senator Dodd and Senator Lincoln in their bill.
Again, we have learned a lot. I think we should have learned a bit of collective humility about the ability to deal with these complicated products.
So we have to build in multiple lines of defense, if you will. Simply requiring the reporting of transactions to a repository--that is good but not sufficient. Requiring that the majority of these instruments be cleared unless they have an economic value or they are so unique that the clearing would be inappropriate--that is a step forward, too, but insufficient. It is only when you put together the entire spectrum of reporting, clearing, and trading of appropriately traded derivatives do you have the full panoply of protections we need to deal with these complicated products today. Frankly, there is a sense that maybe we haven't seen nothing yet. The sophistication, the ingenuity of the financial engineers may be absent at the moment, but it will return, and we need these multiple lines of defense.
There is another point I wish to make. We have to recognize when we are building this new structure that it, too, has weaknesses. One of the most significant weaknesses is that in a clearing platform, if there is not full transparency and if the clearing platform isn't adept at setting margin requirements and collateral, there is a danger that platform becomes a source of systemic risk. And these platforms are dealing with notional values of trillions of dollars. If they misjudge by a little bit, a clearinghouse could have a significant situation in which it is unable to meet its responsibilities. Once again, I think that is a strong argument for, not a single or a double line of defense, but a triple line of defense with respect to trading also.
Because if there is trading and price discovery, they will have a much better idea of what the product really is worth and they will be able to set margin and collateral much more adequately.
There are many issues that have to be dealt with as we proceed through this markup and on to the conference, I hope. But in my mind, clearly the superior vehicle to pursue those ends is the language incorporated in the Dodd bill, and I would urge all my colleagues to reject the amendment by the gentleman from Georgia.
I yield the floor.
